Managing Risks in the bear market - Cabital’s core investment strategies revealed
We examine the most common strategies that risk investors’ assets.
We examine the most common strategies that risk investors’ assets.
It’s been two weeks since the Terra meltdown—one of crypto’s largest systemic shocks. Approximately $60 billion of capital has left crypto, which means yields are drying up fast. As crypto prices plummet, liquidity mining incentives dry up, and on-chain activity slows down, DeFi yields continue to fall.
In fact, the situation is so dire that the crypto Fear and Greed Index dropped to a level of extreme fear not seen since March 2020. The catalyst for the downward swing was the Federal Reserve indicating it would raise interest rates by half a percentage point. This resulted in a wider market selloff, with bitcoin plummeting alongside tech stocks.
The bitcoin price dropped further due to one of the largest crypto crashes to date. It was a classic death spiral scenario started by the TerraUSD (UST) stablecoin losing its $1 peg, followed by its sister token Luna crashing. The scenario added even more downward pressure on the market, which reacted by selling hundreds of million dollars worth of UST, which increased the volume of Luna. The increased volume drove down the Luna price and led to a mass exodus from UST.
The fear currently gripping the crypto market is comparable to the dotcom bubble bursting and the Global Financial Crisis of 2008 according to a Bank of America Research report.
The days when stablecoin deposits into money markets would yield mid-double-digits are long gone, as it’s now exceedingly difficult to find greater than 6% returns in these same protocols.
The drying up of yields also comes amidst outflows from DeFi as a whole, as following the collapse of UST, TVL (Total Value Locked) across all chains has fallen nearly 38% from ~$137 billion to ~$85 billion in the span of a week.
The UST collapse is far-reaching, affecting the number one stablecoin Tether (USDT), which briefly lost its peg to the USD, dropping to 95c on 12 May before swiftly regaining its peg.
To exacerbate the situation, US regulators have raised concerns about stablecoins after the UST crash. This provides regulators with the perfect opportunity to propose sweeping stablecoin regulations and federal compliance.
The reason why APY rates were so high was the fundamental lack of access to debt and credit from traditional banks and traditional brokerages with crypto as collateral. It created the opportunity for DeFi pools to conduct that lending at higher rates because there’s a demand for it.
Stablecoins’ demand constantly exceeds its supply due to exchanges requiring more stablecoin liquidity to maintain trading activity. Furthermore, stablecoins act as a safe haven when crypto prices face high volatility. Another reason is that while DeFi booms, the demand for stablecoins as collateral is also rising.
As a result, stablecoins holders can charge premium interest rates, and crypto exchanges and DeFi firms desperate for stablecoins offer high interest rates to attract new stablecoin lenders.
These DeFi firms then pass those higher rates to the people providing the capital that they’re lending. There’s essentially a much wider spread in crypto than at traditional financial institutions.
Due to the recent market volatility, crypto earn product’s APY on stablecoin has dropped. DeFi firms’ interest rates have been revised to maintain risk aversion policies and to ensure they remain sustainable and competitive within the crypto market.
If you’re a Crypto Earn or lending investor, It’s imperative to understand the common reinvestment strategies used by crypto asset management platforms and DeFi asset managers and firms that use your assets. We’ve taken the liberty of breaking these difficult-to-follow concepts into simpler terms so that you can be confident that you know what the risks are for each particular strategy.
Cabital’s Earn programme has been updated to circumvent the current risks involved with investing assets in a volatile market. As we update our risk-averse strategies to keep your principal safer, the APY rate becomes less. More risk equals higher APY, less risk keeps your assets safe while still turning a profit. Think of it as crypto without the crazy.
We will be taking a dynamic approach to the Fixed and Flexible Savings products’ interest rates, where the rates will float according to market situation. Due to the volatility of the crypto market as a whole, we have opted for this approach to allow us to stay competitive and maintain sustainable earning opportunities for our Cabital Earn users.
For the sake of transparency we’ll consider both Cabital’s strategy as well as riskier strategies found on other platforms. We want to empower investors to make their own investment decisions based on the relevant data.
It’s easy to be swayed by attractive APY rates, but sometimes the risks involved simply outweigh the rewards. We examine Cabital’s strategies followed by two particularly common but riskier strategies that other platforms use.
For Cabital’s own strategy, we insist that security comes first before profitability. Our investment mainly focuses on overcollateralized lending with established trading firms and quant funds. We negotiate the lending term and rates with counterparties personally. To be clear, we know who we are dealing with.
For Cefi, we chose to only work with the leading brands in the crypto space. While for the quant trading funds, we would conduct detailed due diligence on every investment, including but not limited to several in-person conversations and key financial statement screens, to ensure the loan/debt is backed by collateral from the borrower.
Furthermore, we only invest in the fully collateralized stable coin, such as USDT or USDC, it’s safe to say that we conduct the least risky investment strategy among common crypto asset management firms. Our strong partnerships with the leading brands also gives us recourse for lending out our loans. This keeps your principal safe so that you can earn passive income for longer.
A lack of independence and decision making in regards to where your assets are being used. If you opt to invest your principal for a certain amount of time they’ll be illiquid as the principal is locked in. This might prevent an investor from aping into a new project in time to be profitable.
Investors with a high risk appetite may not be satisfied with the risk-averse strategies as they won’t find extremely high yields as one would find with new projects that offer too-good-to-be-true APY rates.
Next, we now look at two common investment strategies that industry players use.
A liquidity provider is an investor who provides their crypto assets to a platform to assist with decentralized trading. In return for providing assets to the pool they are rewarded with fees generated by trades on that platform.
An automated market maker (AMM) is a type of decentralized exchange (DEX) protocol that prices assets based on a mathematical formula. AMMs allow assets to be traded automatically without permission thanks to smart contracts and by using liquidity pools instead of a traditional market of buyers and sellers.
AMMs incentivize users to become liquidity providers by adding a trading pair in exchange for a share of transaction fees and free tokens. Users automatically obtain liquidity provider (LP) tokens from the AMM by providing liquidity.
In most cases, LP tokens represent the crypto assets the user deposited into the AMM along with a proportional scale of the trading fees collected over time in the particular liquidity pool into which the user deposited assets.
Because LP tokens typically accrue trading fees over the time the user’s assets remain in the liquidity pool, the LP tokens potentially accrue value over time as well.
There are currently three dominant AMM models: Balancer, Curve, and Uniswap.
In the case of the Curve AMM model, many assets are pegged to one another resulting in several risks:
1. Investors are exposed to the underlying assets in each pool – should the market lose confidence in one of the pool's assets, a Curve pool can become imbalanced, meaning not all LPs will be able to exit with each asset in equal proportion.
What does this mean? Let's use UST as an extreme example; UST's decline impacted related decentralized finance (DeFi) applications, such as 4pool on Curve.
Launched in early April, 4pool is composed of two decentralized stablecoins, UST and FRAX from Frax Finance, and two centralized stablecoins, USD Coin (USDC) and Tether (USDT). It worked until it didn't: 4pool's liquidity currently stands at a few thousand dollars rather than the millions its creators had hoped for. As an investor/provider, if you have 1% share of the liquidity pool, your current investment might be worth 1% of the few thousand dollars.
2. Investors are subject to two layers of smart contract risk from both Convex and Curve. This risk then evolves into more risks, which are:
3. Another risk associated with liquidity pools is impermanent loss which means one might incur a loss in one’s principal. Losses are automatically incurred when the price ratio of a pooled asset fluctuates from the deposited price. Impermanent loss frequently affects pools containing volatile assets. The higher the price shift the higher the loss incurred.
However, the loss is impermanent as the price ratio will likely revert. The loss will only become permanent once the LP withdraws the assets before the ratio reverts. In the event that the price ratio remains uneven, the potential earnings from LP token staking and transaction fees could cover such losses.
There is a relatively new quantitative trading mechanism in the crypto market that boasts an annualized return of 3% to 7%. This mechanism is spot-futures arbitrage.
This technical strategy consists of three different parts:
This strategy relies on arbitrage (the practice of taking advantage of a difference in prices in two markets) between the spot price (the current price) of an asset and its perpetual future.
A perpetual future is an agreement to buy or sell an asset without a predetermined price without an expiry date.
It would be difficult for traders to predict the settlement price and the cost of funding perpetual futures were it not for a funding mechanism where long (buyers) and short (sellers) traders exchange a funding rate every 8 hours.
The funding rate links the price of perpetual contracts to the spot price to avoid excessive deviations between the two.
When the funding rate is above positive, buyers need to pay proportional funding fees to sellers. This results in long positions closing to stimulate sellers. Conversely, when the funding rate is negative, sellers need to pay proportionate funding fees to buyers. This results in short positions closing to stimulate buyers.
Spot-futures arbitrage uses the price volatility of assets to turn a profit by buying up short positions in the perpetual futures market while also holding the same amount in the spot market.
The above strategies are some of the common investment practices that promise high APY rates but it’s often complicated with excessive risk involved. As such it’s prudent to consider a platform that employs strategies that turn a profit while remaining safe.
A responsible investor should try to understand how each platform makes money and determine their own risk appetite, knowing their risk-reward ratio on every investment decision. Always taking steps to protect themselves from a long-tail risk or black swan event.
We’ll be following up with articles that detail the processes and procedures for making wise investments during a bear market. Considering long-term investments in volatile conditions could lead to extraordinary returns as illustrated by bitcoin’s low price of 2017 versus its all time high in 2021.
This article has been prepared by Cabital Fintech (LT) UAB (the “Company”) and is general background information about some of the Company’s activities at the date of this presentation.
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